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Fincorp - A Painful Lesson on Risk - Eureka Report Article

March 26, 2007
Fincorp a painful lesson on risk
By Scott Francis

PORTFOLIO POINT: Despite warnings from regulators about the dangers of high returns, investors were lulled by Fincorp's promises of regular high returns.

About six months ago Eureka Report published a story about the unquestionably seedy underside of fixed-interest investments, Fixed Yields can be Costly. The story focused on Fincorp, a provider of "unsecured notes", which had fundamental flaws in its structure.

Now Fincorp is in crisis. After Perth-based First Capital pulled out of a plan to buy the company in recent days, Fincorp management called in administrators KordaMentha. The reasons for the failure of Fincorp will come out over time, although the criticism that I made in the article last October - related-party loans, capitalising interest, high-risk property construction assets - will no doubt feature as causes of the collapse.

Initial reports suggest that there are 8000 small investors who will be affected, twice the number caught in the Westpoint collapse, with a total at risk of $300 million. The impact on these people as they start retirement or plan for retirement will be significant.

There is a common theme between Westpoint and Fincorp, and that is the aggressive marketing that was employed by the promoters behind both schemes. At Westpoint "distribution" was through commission-based financial planners. At Fincorp the distribution was through direct advertising campaigns, including press, radio and website advertising - especially on commercial radio stations such as 2GB in Sydney.

There is another key marketing plank in both schemes, the way returns were advertised carefully hid the reality of investment risk. The schemes advertised fixed-income returns paid on a regular basis, not dissimilar to a cash account return. This hid the reality that the underlying investments of these schemes were related to property construction projects. Property construction - especially if it is linked to the promoters raising the money in the first place - is a risky investment in anyone's language.

The reality is this: an investment scheme offering high returns must be high risk; there is no getting around this. This reality hardly comes through in their advertising campaigns, where the regular income is highlighted to such an extent that people can't help but see these as the ideal "one stop" investment solution. A 10% income return paid monthly when bank accounts are offering 6% - it seems like the ideal solution.

This is not the first collapse of such a scheme. The recent failure of Westpoint is still at the top of everyone's mind, and I still run into many people who suffered financial losses from the Estate Mortgage collapse in the early 1990s.

Is there a common thread?

All three funds - Fincorp, Westpoint and Estate Mortgage - relied on property assets for the success of their fund, had high fee structures and relied on aggressive marketing to get investors involved. In the case of Fincorp, this was through direct advertising whereas Estate Mortgage and Westpoint relied on high commission payments to financial planners.

Of course, the strongest link of all was the ability of all three funds to make investors temporarily forget that risk and return must be linked.

Think of Westpoint. Why was it offering returns of 12%? Because the group could not get finance from a bank at 8%, or from a mortgage fund at 10%. That meant Westpoint had to offer higher returns than other market competitors to pull in investors who would otherwise have not had anything to do with them.

The rule that risk and return are linked should protect all investors from:
  • High-yielding fixed-interest investments.
  • Share trading program scams.
  • Property investment spruikers.

It seems, however, that occasional bouts of greed or a lack of financial understanding get in the way of such common sense.

KordaMentha, the auditors who made their name navigating the corporate collapse of Ansett will hold a meeting of creditors in Sydney on Friday.

It will be some time before KordaMentha is able to assess the value of assets related to Fincorp, and the creditors of the company. At this point in time they will be able to start to give some guidance on what investors might reasonably expect. Interest payments on the notes are expected to be frozen, and it is hoped that some guidance will be given as to what percentage of the exposed funds might be recovered by investors. (Investors can get further information through the Fincorp website or through the toll-free number 1800 200 800.)

What does it all mean for retail investors seeking to put money in the allegedly safe haven of fixed interest instruments?

Fixed-interest investments have a core place in any portfolio. They should be low-risk, traditional fixed-interest bonds and term deposits.

But bear in mind that unsecured notes, debentures, mortgage funds and promissory notes are not traditional fixed-interest investments. They are high-risk investment vehicles, often linked to property construction risks even though they are regularly - and legally - promoted in a similar manner.

If you want to use these "new wave" pseudo fixed interest investments, they should:

  • Only form a small part of your portfolio.
  • Be acknowledged as high-risk investments.
  • Only be used with a full understanding of the underlying investments.
  • Be understood as a very different choice compared to traditional fixed-interest investments.

My strong advice would be to avoid them completely. If you want higher returns in your portfolio then don't chase it through these instruments, instead invest a greater portion of your portfolio in the traditional growth asset classes of shares and property.

Foxes and hen houses

Just as you should never put a fox in charge of a hen house, a key part of the Westpoint and Fincorp failures must be that fact that Westpoint and Fincorp were playing two roles: they were (supposedly) taking fiduciary responsibility for (a) lending investors money at the same time as they were (b) borrowing this same money for property construction schemes.

This is a highly unsatisfactory situation. How can a company really provide robust assessment of a lending application on behalf of investors when the application effectively comes from itself? There are no "Chinese walls" thick enough to make such an obvious conflict of interest work.

ASIC's role

There will be a lot of huffing and puffing about ASIC's role in protecting consumers as the Fincorp collapse is considered. ASIC's record on Fincorp is strong: they have once stepped in to withdraw a prospectus that did not properly outline risks and have continually warned consumers about the risks of high-yielding fixed-interest investments. If there is a failure with ASIC it would seem to lie in the resources that it is given to deliver its message because it has been vocal and consistent in warning of the risks of Fincorp-style investments.